DoD: Definition of Default

Following the financial crisis, the European Banking Authority (EBA) has established tighter standards around the definition of default (CRR Article 178) to achieve greater alignment across banks and jurisdictions. These need to be implemented by the end of 2020.

European regulators have adopted new detailed standards on how banks need to recognize credit defaults for prudential purposes to increase consistency across countries and banks. The deadline for compliance is the end of 2020. Banks that have carried out a quantitative impact analysis have found that the new standards can materially impact the number and timing of defaults, calling into question the validity of existing models and processes. The impact varies significantly across banks (depending on approach for estimating regulatory capital and pre-existing default definition) as well as across individual portfolios within the banks.

The new DoD consists of new set of standards that are more detailed and prescriptive, and will have significant impact on governance, data, processes, systems and credit models. The impact on capital requirements depends on several influencing factors, including type of approach for estimating capital requirements (IRB or Standardised Approach), current implemented default definition and portfolio specifics. For approved IRB capital models, the new standards are deemed to be a material change and hence requiring formal re-approval of a Competent Authority, irrespective of capital impact. All banks need to implement the new standard by 31 December 2020 for reporting to start 1 January 2021.

Introduction of new absolute and relative materiality thresholds for the purposes of DPD counting; when both thresholds have been breached for 90 days, a default has occurred. ECB and most NCAs have adopted the EBA RTS thresholds:

  • Retail: 1% relative and €100 absolute.
  • Non-retail: 1% relative and €500 absolute The notable exception to this being the PRA in the UK which has adopted a 0% relative and a zero absolute threshold for retail exposures to minimize the operational impact that changing the widespread practice of determining 90 DPD through a ‘months-in-arrears’ approach would imply. It should be noted that NCAs outside the Eurozone have adopted absolute thresholds in local currency; these have so far been specified in even amounts broadly equivalent to €100 and €500. Where banks apply default at obligor level, they should ensure materiality thresholds are also applied at obligor level. Banks may opt to use lower thresholds as an additional unlikeliness to pay trigger.

The standards specify a strict and limited set of so-called technical defaults, i.e. false positives that are caused by technical issues; generally data or system errors, or failures or delays in recognizing payment.

Clarification on arrangements to be treated similar to bankruptcy, including but not limited to all arrangements in annex A of Regulation (EU) 2015/848 on insolvency proceedings. This includes not only such arrangements directly involving the institution but also such arrangements the debtor has with third parties.

Minimum regulatory probation period of 3 months for all defaults with the exception of distressed restructuring, where a 1 year minimum probation period applies. Banks have to monitor the behavior and financial situation of the obligor in probation to support cure after the probation period expires. There is an option for banks to apply different probation periods to different types of exposures (as long as they meet the minimum requirement). In case the defaulted exposure is sold, the bank needs to ensure the probation period requirements are applied to any new exposure to the same obligor.

Generally, when a credit obligation defaults which is related to an exposure where default applies at obligor level, all other exposures of the obligor should also default, including those where the institution applies default at facility level. When a credit obligation defaults which is related to an exposure where default applies at facility level, the institution should only consider other exposures of the obligor in default for certain UTPs.

Establish programme governance to provide coordination across policy decisions, approaches, external communication, and timing of implementation and reporting. Some banks may also require coordination across multiple entities and jurisdictions where systems and processes are shared. Define internal policy and standards, including with regards to available discretions and jurisdictional discrepancies in the application of the new DoD. This is ideally informed by the impact assessment, and provides sufficient guidance for interpretation across models, business lines, and business processes to be consistent.

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